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Court invalidates SEC's less-than-clear adviser rules


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April 02, 2007

Court invalidates SEC's less-than-clear adviser rules

Aaron Pressman

A little noticed D.C. Court of Appeals ruling at the end of last week struck an important blow for ordinary investors. The court threw out the Securities and Exchange Commission's nonsensical rule allowing brokers to charge fees seemingly for financial advice without following the rules that apply to financial advisers under the Investment Advisers Act.

By law, there's a hugely critical distinction between brokers and true financial advisers. Brokers have a limited legal duty simply to recommend suitable investments. Something that's merely suitable doesn't have to be best or most suitable or even a great idea. And it's often a product that pays the broker the biggest commission behind the scenes, even if it's "free" to the client. On the other hand, financial advisers are fiduciaries. That means they have to act in the best interest of the client. A front-end loaded, actively managed stock fund may be suitable but a low-cost, no-load index fund may be a far better fit.

The confusion arose after brokerage firms started re-labeling their brokers "advisers" and forgoing the usual commission fee per trade in lieu of an annual fee charged as a percentage of assets. An adviser who charges an annual fee? Hmm, sounds like a financial adviser and I'm sure some of the marketing folks hoped the confusion would work to their advantage. But, at the same time, brokers were loath to be categorized legally as "investment advisers" because they didn't want the fiduciary duty that comes along with the job. Frankly, they snowed a lot of customers and the results were lawsuits, arbitrations and regulatory fines for poorly-designed, fee-based brokerage accounts, as I wrote about last December and the year before.

The SEC deserves some of the blame. At the brokerage industry's behest, the commission had attempted to squeeze an exemption to the Advisers Act through a tiny loophole. "Any broker or dealer" is exempt from the Investment Advisers Act if he gives advice that is "solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor." Further down the list, a final exemption was reserved for "such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or orders."

It's that last sentence, known as Paragraph (F), that the commission used, as if the definition of the brokerage exemption was somehow not clear. Crazily enough, brokerage firms running fee-based accounts exactly are "any broker" receiving "special compensation" as opposed to just commissions on trades. As the court wrote: The word "any" is usually understood to be all-inclusive. Yeah, usually.

08:30 AM

Financial Advisers

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